As the U.S. defense industry tries to avert $500 billion in automatic cuts to national security spending, one of its biggest hurdles may be its own recent success.
The five biggest U.S. weapons makers, led by Lockheed Martin Corp. (LMT:US), last week reported higher profit than analysts had expected for the second quarter. Analysts estimate earnings of four of the companies will rise next year.
The optimism contrasts with the “unemployment Armageddon” that Marion Blakey, president of the Aerospace Industries Association, has predicted will occur if the scheduled reductions begin Jan. 2. The industry’s approach may backfire if Congress and the public view the warnings as a bid to protect their earnings, said Don Kettl, dean of the school of public policy at the University of Maryland.
“The risk is that they would move from an argument in favor of national defense to an effort to try to save their profits,” he said in an interview. “That’s a very thin line.”
Contractors entering the sequester debate risk raising concerns among investors, said Chris Preble, a vice president at the Cato Institute in Washington, which advocates for limited government.
“If you’re trying to reassure investors, then you don’t want to be crying the sky is falling,” Preble said in a phone interview. “There’s a real delicate balancing act there between wanting to lobby hard to prevent cuts and sequestration, but to also convey the stability of the company.”
National security and domestic programs face $1.2 trillion in across-the-board reductions over a decade if Congress and the White House don’t reach a deficit-reduction agreement.
Democrats are insisting that Republicans accept some tax increases in exchange for altering the defense cuts. No proposal to avoid the reductions has gained support.
The automatic cuts would force the Pentagon to reduce purchases of weapons such as Lockheed’s F-35 jet and General Dynamics Corp. (GD:US)’s Stryker combat vehicle, Deputy Defense Secretary Ashton Carter said in written remarks for a House Armed Services Committee hearing today.
The Aerospace Industries Association, which represents contractors such as Northrop Grumman Corp. (NOC:US) and Boeing Co. (BA:US), has predicted the automatic cuts may cost 2.14 million U.S. jobs. Robert Stevens, chairman and chief executive officer of Bethesda, Maryland-based Lockheed, said July 18 his company would have to cut 10,000 positions if the reductions occur.
“Fundamentally, the nation does well when its defense industry is financially healthy,” Wes Bush, chief executive officer of Falls Church, Virginia-based Northrop, said in an interview after a July 30 rally in Arlington, Virginia, against the cuts.
The industry’s warnings may be at odds with the profit outlooks of the biggest U.S. defense contractors.
Analysts surveyed by Bloomberg predict those manufacturers will generate $12.93 billion in profits next year, 4.4 percent more than estimated net income of $12.34 billion this year.
The top five weapons makers are Lockheed, Chicago-based Boeing, Falls Church, Virginia-based General Dynamics, Waltham, Massachusetts-based Raytheon Co. (RTN:US) and Northrop Grumman. Adjusted earnings per share were estimated to rise next year for all of the contractors except Northrop, according to the analysts surveyed by Bloomberg.
Investors aren’t punishing the largest contractors, even as the threat of sequester looms. A Bloomberg index of the nine biggest manufacturers of U.S. weapons systems rose 11 percent this year through yesterday, beating the Standard & Poor’s 500 Index, which gained 9.7 percent.
Lockheed’s most recent quarterly results reflect the strength of its portfolio, Chris Williams, a company spokesman, said in an e-mail.
“Sequestration is another matter entirely,” Williams said. With little insight into how it will be carried out, “we’ve been unable to more precisely estimate the adverse impacts,” he said.
Defense companies are starting to “stray into the area of politics, and that comes with a completely different bucket of risks,” said Robert Stallard, a London-based analyst at RBC Capital Markets.
Making public statements about sequestration may result in politicians calling on defense companies to justify their financial returns and their executive compensation, Stallard said in a phone interview.
“It is potentially a risk down the line that these politicians come back with things that maybe the defense industry is not prepared for,” he said.
Stallard said he believes Congress and the White House will reach an agreement to delay the automatic cuts after the November election.
“The only thing there seems to be agreement on in D.C. at the moment is they don’t like the sequester,” he said.
Ben Freeman, national security investigator at the Project on Government Oversight, a Washington-based group that tracks government spending, said it’s “hard to understand a lot of this doomsday rhetoric” considering the profitability of the defense industry.
“The contractor lobby is doing a brilliant job, frankly, of framing this as an economic argument that if you cut defense you’ll kill the economy,” he said in a phone interview.
The estimate of 2 million job losses tied to the sequester doesn’t account for the economic impact of other potential uses of defense spending such as tax cuts or greater investment in education, Freeman said.
The figure comes from a George Mason University study by Stephen Fuller that was funded by the Aerospace Industries Association.
Fuller, director of the university’s Center for Regional Analysis, defended his work as a “totally objective analysis.” The industry group paid about $17,500 for the study, he said.
“I never allow the client to tell me what the answer needs to be,” Fuller said in a phone interview. It doesn’t make sense to consider other uses for the money that would be cut under sequestration because none of it could be used for other purposes, he said.
No ‘Panic Mode’
Not every company is taking so active a role opposing sequestration.
Raytheon is “not in a panic mode,” Dave Wajsgras, the contractor’s chief financial officer, said in a phone interview. “I’m quite comfortable with how we’ll perform in the future.”
Some defense executives seem to be “uncomfortable” with the “very visible” approach peers such as Lockheed have taken in arguing against the automatic cuts, said Gordon Adams, a professor at American University in Washington who was an official in the White House budget office during the Clinton administration.
“There’s a political risk here for them of being associated with the rhetoric,” he said. “It gets tough to engage in the type of business they have to do if they’re known to be publicly partisan.”
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